Gritty Travels
The road out of the pandemic has been a rocky ride in terms of monetary policy and investment markets. Public equity valuations and fixed coupon bonds have recently been experiencing the effect of a capital rate adjustment. Moreover, the adjustment process to establish a new price equilibrium has hampered asset prices and restored interest rates to pre-pandemic ranges. But behind the scenes of what feels like turbulent times is a functioning economy.
The first quarter's preliminary estimate of Real GDP showed a contraction. The governmental agency that tracks this data reported an annualized one and one half percent drop in economic activity in the first quarter of the year. Real GDP contracted for several reasons, including a larger trade deficit, inventory declines, construction slowdowns, and reduced government spending. On the other hand, consumer spending and non-fixed investments remained strong in the first quarter. Lastly, the agency's forecast goes through two more revisions before it becomes final.
In areas where the economy showed weakness, activity may be temporarily impaired or in transitory setbacks, particularly in the case of inventories. If companies could receive inventories on a timely basis, they'd likely have no trouble shipping them out. Likewise, if there was a way to move people back into the job market more quickly, businesses could get back to operating at scale. Therefore, present-day frictions on the supply side that create backlogs and bottlenecks are probable reasons for holding Real GDP back. Hopefully, the day is near when the balance in labor and product is restored, and the economy's supply chain reinvigorates.
The demand side of the equation shows no letting off, for many good reasons. For example, consumers are currently directing a smaller portion of their monthly budget towards servicing debt. That's a result of the pandemic's economic response, as the environment opened up access to cheap and easy-to-access lines of credit. Further, labor demand is red hot. There are nearly two jobs available for every unemployed person, giving at least some income access to those who want it. Finally, payroll data shows that wages have had upside gains, which is good while higher-than-average inflation rates exist.
A slew of corporate earnings reports has crossed the path of many investors by now. So far, it appears that sales and earnings finished near expectations. As expected, there were beats and misses, but one common theme seemed clear: supply constraints were adversely impacting costs and financial projections. As a result, headwinds that might compress profit margins gave reason to lessen equity valuations relative to balance sheet book values.
But even though valuation rates have risen and sent prices down, one good thing has popped back up in interest rates. Namely, investors generally believe that current yields on government bonds will cover the cost of future US dollar devaluation and provide some extra and real return incentive. Specifically, investors see inflation at two and a half percent annually later on in the future. Conversely, today's US government yield is three percent on a ten-year loan. Therefore, an investment in the yield could result in a one-half percent annual return above and beyond the average long-run inflation. Markets have not seen this type of yield advantage in a long time, and it will hopefully restore balance to prices in the near term.
High conviction already exists in the markets that short-term interest rates will rise, as evidnced by the current yield curve. So the question regarding monetary policy is: how will it impact long-term growth? Unfortunately, long-dated bonds haven't seemed to quite resolve this issue yet. However, the bond market may be close as investors have priced in forward interest rates that may clear the future rate of inflation. That could restore stability to market prices.
